Deflation Reality Check
The central banks must drop the anti-inflation mandate.

Mr. Malpass is the Chief International Economist for Bear Stearns.
October 23, 2001, 8:00 a.m.

Deflation implies a longer recovery period after the bottom, and a longer-than normal period of weak corporate earnings. Going forward, one can expect waves of disappointment as real economies around the world underperform the market’s expectation for a speedy recovery.

The signs of deflation are clear. Real interest rates are high practically worldwide. Commodity and gold prices are low. Loan demand is generally low, and global economic activity is declining. Yet central banks are in deep denial: The following comments from October 17 and 18 tell a grim tale of central bankers wearing blinders — focusing only on inflation, not deflation.

• Speaking to the Diet on October 18, Bank of Japan Governor Masaru Hayami said: “We will need to watch very closely whether the economy enters a deflationary spiral.”
Reality Check: Prices have been falling in Tokyo since at least July 1994, with all the expected negatives — weak equities, low interest rates, falling investment, falling consumption.

• European Central Bank president Wim Duisenberg said on October 17 that inflation is his "main focus." Otmar Issing, the central bank's chief economist, said that policy-makers should concentrate on curbing inflation.
Reality Check: The issue is to guard against deflation. Europe is on the brink of recession. The inflation rate is falling fast. The European Central Bank began 2001 with interest rates 1.75% below the Fed (4.75% vs. 6.5%); it now stands 1.25% above the Fed (3.75% vs. 2.5%), a 3% swing in relative tightness given their similar inflation paths.

• Asked whether the Bank of England would soon cut rates, an official said, in typically elliptical central-bank language: “The September 11 tragedy will affect the supply side as well as the demand side, raising costs for security, insurance, and other factors of production.”
Reality Check: Decoded, this warns of “too much money chasing too few goods” as companies struggle to adjust. However, given the investment surge of the 1990s, it’s unlikely that the world will see shortages or corporate pricing power any time soon. The Bank of England has lowered rates from 6% to 4.5% during 2001, leaving its rate way above the U.S. and Europe despite benign inflation.

• In her October 17 confirmation hearing before the U.S. Senate Banking Committee, Susan Schmidt Bies, a nominee to the Fed Board, said: “Based on my experience over the years, I believe that this [growth and low unemployment] can only be accomplished by restraining inflation . . . the primary focus of monetary policy is to contain inflation. . . . ”
Reality Check: What of deflation?

• In a similar hearing, Mark Olson, another Fed nominee, said: “As a banker, I witnessed first-hand the difficulties caused by both recession and high inflation in more volatile economic times.”
Reality Check: No U.S. central banker or economist has yet lived through deflation, so their experience is heavily biased toward fighting inflation.

• Speaking to the Japan Society on October 17, former U.S. Treasury Secretary Robert Rubin said: “I think the answer to Japan’s economic problems lies in the area of structural reform, things like open credit markets and dealing with fiscal problems. I don’t think a weak yen is the answer to Japan’s economic problems.”
Reality Check: Japan has sunk into a deep recession because of bad monetary policy. Structural and fiscal reforms in the face of deflation will make the situation worse. A commitment to a non-deflationary monetary policy would restart growth.

Remove the Blinders
In the statistical data, the U.S. covers up its deflation through price supports, price floors, import quotas, anti-dumping barriers, agricultural subsidies, and on and on. But Hong Kong’s dollar-linked and more open economy already shows years of price declines and near-record real interest rates, giving an indication of the degree of deflation at work in the global economy.

The solution to the global recession requires full attention be put on the deflationary nature of global monetary policy. The central banks need to remove their blinders. If they continue to think in terms of an anti-inflation mandate and ignore the deflation, there will be waves of disappointment in the global economy as the deflation works its way through prices.

Today, world central banks are still causing deflation, implying a drawn-out slowdown extending well into 2002. Yes, the U.S. economy is a resilient economy, but chances are it won't be enough to lift the world as long as deflation persists.